While multifamily property posted robust growth and the office and industrial sectors saw continued progress, overall demand for U.S. retail space remained decidedly tepid in the third quarter, according to CoStar’s Third Quarter 2012 Retail Review and Outlook presentation.

Retail sales started the year strongly before suffering a summer swoon. While consumer spending is on the rise again in recent months, concerns about the fiscal cliff and the effects of the European economic slowdown have caused uncertainty about retail sales growth. As a result, retail property fundamentals have more-or-less moved sideways for eight quarters now.

U.S. retail properties absorbed a scant 7 million square feet in the third quarter of this year. As a basis for comparison, the state of Texas alone averaged 6 million square feet in retail space absorption per quarter in 2006, according to CoStar’s analysts.

Meanwhile top retailers are determining clear winners and losers among local retail centers as the best shopping centers attract the bulk of tenants competing for available space while bypassed locations struggle with higher vacancy and eroding demographics, according to Suzanne Mulvee, director of retail research for CoStar's Property and Portfolio Research (PPR) division, and PPR real estate economist Ryan McCullough.

In some cases, retailers are opting for shiny new space over the plentiful available existing space that happens to be located in less-than-prime neighborhoods or marginal trade areas that don’t fit their needs, McCullough said.

For example, two of the three retail centers under construction in excess of 500,000 square feet nationally are both in Las Vegas, a housing bust market with a retail vacancy of 10.7%.

"We’re seeing big, good tenants sign up for these construction projects. There’s plenty of (existing) vacant space, but they don't want it, they want to be in certain key locations, and that could get the construction ball rolling again very soon."

Fabulous Centers Get All the Rent Hikes

While asking rents continue to slip lower across much of the available retail space, stronger shopping centers are logging rent gains. Simon Property Group (NYSE: SPG), the largest owner of malls and shopping centers, reported 3.8% rent growth in its portfolio for the third quarter, McCullough noted.

"This tells me that good centers no longer feel the need to compete on price; they feel comfortable to start pushing rent gently again," McCullough said.

Rent reductions in such metros as Orlando and Sacramento and Salt Lake City are still among the highest in nation, while South Florida is seeing 4% year-over-year growth, and the San Francisco Bay Area and Seattle/Puget Sound reported 2% rent growth. In general, areas with more geographic density have fewer unproductive retail centers, while even fast-growing but geographically dispersed areas like Houston and Dallas appear to have more under-performing retail locations.

Discounters and high-end retailers are enjoying success, while retailers in the middle, including big box chains such as Sears Holding and Food Lion are continuing to go dark.

"This is a problem. As we try to build some momentum in the retail sector and build up that leasing volume, we continue to run up again these weaker chains giving back space," Mulvee said. "While this Darwinian retail environment isn’t new, it’s being accelerated by the Internet, by the ability for consumers to easily go to a different location, especially online."

A CoStar analysis of vacancies across all types of retail -- neighborhood, strip, community and power centers, and mall -- shows a persistent divide between the retail haves and have nots.

Neighborhood centers had an average 11.1% vacancy in the third quarter 2012. However, “competitive" centers, excluding properties with vacancies of 40% or greater, had a vacancy rate of 7.2%. The vacancy rate for malls, including dead or dying centers was 5.8%, compared with 4.7% for more competitive properties.

"Not much is changing. There’s little ability to 'fix' a broken center today, given the lack of leasing volume in the marketplace," Mulvee said.

Higher Yields Coming for Investors?

One bright spot for retail may be in investment sales, which are beginning to see improvement with sales volume at or near its 10-year average over the last few quarters. The CoStar Commercial Repeat Sales Index is ticking up, showing a broadening recovery of average retail properties.

Distressed transactions are decreasing, and retail capitalization rates remain elevated relative to other property types and the 10-year Treasury. At some point, cap rates will revert to their long-term average, which means outsized cap rate compression for retail could be coming in the future, which would be good news for investors.

Meanwhile, same-store NOIs at better properties owned by selected mall, outlet center and shopping center REITs are back on the upswing.

"When you combine these wider spreads, rising NOIs and expectations of possible cap rate compression, it's a pretty good story for retail investors. Investors are starting to warm up to the story that retail sales are up, same-store up and it’s getting better for national credit tenants," McCullough said.

Based on changes in pricing per square foot now versus the period of 2009-11, mall prices have shot up 25% and investment volume is up 70%. But, like retailers, investors only want the best properties. More than 40% of investment activity in 2012 is concentrated on properties with less than 5% vacancy, compared with 30% in 2009-11, and nearly 30% of investment dollars are going into properties with 5-10% vacancy, compared to just over 20% in 2009-11.

"People apparently are scared to death by the dead malls or the ones that appear to be dying," McCullough said. "But reports of the death of the mall have been greatly exaggerated."

"Some of the weaker centers may not be relevant to retailers any longer," Mulvee added. "There isn’t that ability to fix that broken center, at least not with traditional retail tenants, and investors are really shying away from taking on that leasing risk.

"At some point you trip too much vacancy in a center and now it’s in that death spiral because you lose traffic, shoppers go elsewhere and most centers don’t recover."

Interestingly, if malls are removed from the equation, investors are developing a greater appetite for risk and distress. Investors may not be willing to take on the risk of rehabbing a mall, but perhaps they may be aggressive enough to take on more risk repositioning a strip center, McCullough said.